One of the primary factors in your business acquisition search will be size, but are you sure you know what size business you can afford to buy?
It is common for businesses to be identified by their revenue, but valued on a multiple of cash flow. The reason being that two companies might be producing the same amount revenue, but one is a cash cow with a 40% cash flow margin while the other is just scraping by with 4% profit margins. The standard measure of cash flow for small businesses is Seller’s Discretionary Earnings (“SDE”). This is calculated as the pre-tax earnings + interest + non-cash expenses (depreciation and amortization) + owner benefits (salary, discretionary spend, etc.).
When you identify a business by its SDE rather than revenue, you can start to understand price guidance offered by many sellers. Most small businesses with SDE less than $300,000 are sold at a multiple of 2 to 3 times seller’s discretionary earnings. So, if you see a business for sale listing with SDE of $200,000. You can reasonable assume that the business’s value is $400,000 – $600,000. Valuation is an art of course, and there are many factors that lead into a business’s value, so take this only as a rule of thumb. Oftentimes businesses are offered with real estate, significant working capital assets, excess inventory or with significant equipment assets that may outweigh the SDE valuation. These are all reasons that a business’s listed price might be higher than its SDE would lead you to believe. Or, it can just be overpriced.
But is this a business you can afford to buy?
Many small businesses are acquired using SBA 7a loans (We wrote a separate blog post on these loans which you can read here). One of the highlights is that SBA 7a financing often requires ~10% equity down payment and only 5% needs to be buyer cash (the other 5% can be a seller note). This means that if you were interested in buying the company for $500,000, according to SBA rules you will need minimum $25,000 cash equity. Keep in mind that this is oversimplified and other costs will be included in the loan (like a working capital injection and closing fees). Another thing to keep in mind is that we are not recommending only putting 5% down, nor will all banks follow SBA rules strictly. Remember, it is their money that is being loaned and they have significant sway on to whom, for what and how much they’ll lend. Don’t forget that SBA loans require personal guarantees.
Being slightly more conservative, if you’re interested in learning what size business you can afford, multiple your capital available for an acquisition by 8 and 10. This provides an approximate range for you to start your search if you plan on using SBA financing.
For example, if you have $75,000 available to buy a business, you can reasonably assume to afford a business worth between $600,000 and $750,000. The scenarios and advice offered here are general guidelines and every situation is different.